The Federal Government Debt: Its Size and Economic Significance

After being in surplus between FY1998 and FY2001, the federal budget has now registered deficits for the last four fiscal years. The budget, given current policies, is now projected to remain in deficit through FY2011. When the budget was in surplus, the policy issues were whether or not it would be worthwhile to pay off the national debt and whether or not the existence of public debt provided some economic benefits. For the time being, those are no longer issues. Instead, the question is what are the risks associated with a rising federal debt.

At the beginning of 2007, total gross federal debt is over $8.6 trillion. While gross federal debt is the broadest measure of the debt, it may not be the most important one. The debt measure that is relevant in an economic sense is debt held by the public. This is the measure of debt that has actually been sold in credit markets, and which has influenced interest rates and private investment decisions. At the beginning of 2007, the debt held by the public is just over $4.9 trillion. The remaining $3.7 trillion was held by various federal agencies.

In the short run, growth in the public debt affects the composition of economic output. Federal government borrowing adds to total credit demand and tends to push up interest rates. Higher interest rates increase the cost of financing new investment in plant and equipment and thus may tend to reduce the stock of productive capital below what it might otherwise have been.

In the long run, the relationship between the growth rate of the federal debt and the overall rate of economic growth is critical to financial stability. As long as the debt grows more rapidly than output, the ratio of debt to gross domestic product (GDP) will rise. Perpetual debt growth in excess of economic growth is an inherently unstable situation. Whether or not the debt-to-GDP ratio is on such a path depends on the budget deficit, the rate of interest, and the rate of growth in GDP.

What matters most, as far as financial stability is concerned, is what investors believe to be the long-run trend in the debt-to-GDP ratio. If large deficits are expected to persist, or if the interest rate on the debt is expected to exceed the growth rate indefinitely, then at some point the federal government may begin to find it more difficult to sell new securities. The federal government, however, has a source of credit not available to individual businesses, the Federal Reserve Bank.

Should the federal government be unable to find private sector buyers, the Federal Reserve might buy the securities that otherwise the government would be unable to sell. Should it decide to do so, then the threat is no longer one of government insolvency, but rather of inflation. This report will be updated as warranted.